Guru Investment Theses on Google Inc

Chris Davis Comments on Google - Oct 03, 2013

Our third largest position is an extraordinary technology company dedicated to organizing the world’s information and making it both useful and accessible to anyone, anytime, anywhere. In just 15 years, this company’s remarkable collection of engineers have been so successful that the company’s once strange-sounding name, Google (GOOG), has become a verb synonymous with Internet search. As a business, the company currently receives payment for the value of its technology by selling advertisers the right to place ads above or alongside a user’s search results. Such advertisements currently represent 95% of Google’s revenue, making the company the largest and most profitable advertising company in history. Because search has the advantage of allowing advertisers to control and track the return on their advertising expenditures (for example, they only pay if the ad is clicked on), they finally have a response to the lament of department store owner John Wanamaker who famously complained, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.”

In its core Internet search business, Google is the unquestioned global leader, with a 67% share of all Internet searches in the United States (compared to Bing’s 16% and Yahoo’s 12%), a stunning 93% share in Western Europe and a 74% share globally. While an estimated 80% of all searches still come from desktop PCs and tablets, Google is also the leader in mobile searches, which already account for 20% of searches and are growing rapidly. Google’s costs are largely fixed and consist of people and data centers. Each additional time a user clicks on an ad, the incremental revenue represents almost 100% profit. Google’s current operating margins in the low 30% range understate the company’s true profitability as they include enormous investments in innovative products such as Android, Google+, Google Wallet, and Google TV, which help widen its competitive moat, as well as “blue sky” products such as Google Glass and the Google car.

The company benefits from a number of key growth drivers including growth in the number of people and devices accessing the Internet both here and abroad, the continuing growth in the number of searches performed per user, the increasing number and value of display advertisements, and the global spread of smartphones through which billions of new users can gain access to the Internet. The company has significant competitive advantages, the most important of which is scale. Google’s industry-leading scale means that it has more advertisers bidding for key words than its competitors, which allows it to earn a disproportionate amount of search revenue (for example, Google has a 67% share of searches but an 82% share of search revenue). Scale also generates more search data, which leads to better search results, and more ads, which lead to better targeting and more useful ads. In addition, scale results in a larger R&D budget, which leads to an improved product and the ability to attract top engineering talent, which then attracts other talented engineers.

Google’s people and corporate culture are further important sources of competitive strength. As its co-founder and CEO, Larry Page, has only just turned 40 and is passionately engaged in the business, the company’s intensely innovative, driven and entrepreneurial culture is unlikely to change for the worse and, more important, the company is likely to remain the employer of choice for the country’s top technology minds. From a shareholder point-of-view, however, the culture is not perfect. The opportunistic repricing of stock options during the financial crisis was extremely unfortunate and, in our view, unnecessary. In addition, the company’s pay policies are structured so that a Google employee will rank in the 95th percentile or higher compared to employees performing a comparable function at other companies. However, this policy will be truly problematic only if the company’s employees fail to perform at the 95th percentile level (a dynamic that New York Yankee fans have come to understand all too well!). Finally, the company has a dual-class share structure, which means that public shareholders (like us) have no say about the direction of the company. Taken together, such policies may indicate a culture that favors employees over shareholders. However, having spent time over the years with management, our tentative response to this troubling aspect of an otherwise wonderful company is that management’s cynical view of investors is shaped by their formative exposure to the Wall-Street-hyped nonsense of the millennial Internet bubble and the short-term analysts and traders that have tended to leap in and out of Google’s stock based on quarterly results. Ultimately, we think the idealism, passion and principles of the founders are genuine. We would note, for example, the total compensation of Larry Page and co-founder Sergey Brin since going public has been $1 each per year.

At a share price of $880, Google has a $259 billion enterprise value, and trades at approximately 21 times estimated fiscal year 2013 owner earnings and 17 times estimated fiscal year 2014 earnings. Given the company’s growth prospects and competitive advantages, we consider this a fair price for a great company. The balance sheet is strong, with a net cash position of $49 billion, or 16% of the company’s market capitalization. The company has consistently generated high returns on invested capital, ranging from 38% to 48% over the last five years.

A main risk with the investment is that incremental searches, mainly in emerging markets and on smartphones, are less profitable than historic searches and might be insufficient to offset slowing core desktop PC search in the United States and Europe. Although we have seen revenue per search falling in the last few years, we believe that over time the value of both emerging market and mobile searches will rise. For emerging markets, we expect that increasing Internet penetration (globally now 39% compared with 81% in the United States) and a rising middle class will increase Google’s revenue per search from today’s low levels. In smartphones, we believe advertisers will start building mobile specific advertising campaigns using location-based advertising and features such as “click to call” and “click for directions.” A second risk would come from users choosing to bypass Google because a more useful search mechanism developed based on data that Google cannot access. At this point, the only plausible contender would be Facebook’s attempt to develop ways of searching for information from your “friends,” which might be more relevant than information from the Web in general. While this seems possible at the margin, it remains more theoretical at the moment. A final important risk may be a lack of discipline in capital allocation or a gradual trend toward “diworsification.” While there is some debate about the apparently high price paid for Motorola’s handset business, for example, the success of a number of Google’s other acquisitions, including Android and YouTube, lead us to give them the benefit of the doubt.

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Google Inc was incorporated in California on September 4, 1998 and reincorporated in Delaware in August 2003. The Company is a technology company engaged in improving the ways people connect with information. The Company's business is mainly around the following areas: search, display advertising, operating systems and platforms, enterprise and hardware products. The Company's search technologies sort through an ever-growing amount of information to deliver relevant and useful search results in response to user queries. It integrates features into its search service and offer specialized search services to help users tailor their search. In January 2012, the Company launched Search plus Your World. When a user performs a signed-in search on Google, the user's results page may include Google+ content from people that the user is close to. Relevant Google+ profiles and Google+ pages related to a specific topic or area of interest may also appear on a user's results page. Advertising includes Google Search, Google Display, Google Mobile and Google Local. AdWords is the Company's auction-based advertising program, which delivers advertisements that are relevant to search queries or Web content that they are a form of information in their own right. With AdWords, advertisers create text-based advertisements that then appear beside related search results or Web content on its Websites and on partner Websites in its Google Network, which is the network of third parties that use the Company's advertising programs to deliver relevant advertisements with their search results and content. The Company, along with Open Handset Alliance has developed Android mobile software platform that any developer can use to create applications for mobile devices and any handset manufacturer can install on a device. Google Chrome OS is an open source operating system with the Google Chrome Web browser as its foundation. The Chrome browser runs on Windows, Mac, and Linux computers. Google TV is a platform that enables the consumers the power to experience television and the Internet on a single screen, with the ability to search and find the content they want to watch. The Google TV platform is based on the Android operating system and runs the Google Chrome browser. Google's enterprise products provide Google technology for business settings. Through Google Apps, which includes Gmail, Google Docs, Google Calendar, and Google Sites, among other features, the Company provides hosted, Web-based applications that people can use on any device with a browser and an Internet connection. In addition, the Company provides its search technology for use within enterprises through the Google Search Appliance, on their public-facing sites with Google Site Search, and Google Commerce Search. The Company also provides versions of its Google Maps Application Programming Interface (API) for businesses, as well as Google Earth Enterprise (a behind-the-company-firewall softw

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